STRATEGIC DEBT SERVICE

When firms experience financial distress, equity holders may act strat egically, forcing concessions from debtholders and paying less than th e originally-contracted interest payments. This article incorporates s trategic debt service in a standard, continuous time asset pricing mod el, developing simple closed-form expressions for debt and equity valu es. We find that strategic debt service can account for a substantial proportion of the premium on risky corporate debt. We analyze the effi ciency implications of strategic debt service, showing that it can eli minate both direct bankruptcy costs and agency costs of debt.